Key themes from the December FOMC policy meeting

Here are the key themes to take from the December FOMC policy decision released earlier on today.

Statement

Labour market – Members note that conditions had ‘improved further’ in December as opposed to ‘improved somewhat’ in October. Underutilisation is now ‘continuing to diminish’ as opposed to ‘gradually diminishing’ previously.

Inflation – As was the case in October members stated that inflation continues to run below their longer-run objective although in December they add that this is partly a result of lower energy prices. They also note that market-based measures of inflation compensation have declined ‘somewhat further’ as opposed to just ‘further’ in October. In what it slightly surprising given recent market pricing the committee, as they did previously, stated that ‘survey-based measures of longer-term inflation expectations have remained stable’. They also noted that they expect ‘inflation to rise gradually toward 2 percent as the labour market improves further and the transitory effects of lower energy prices and other factors dissipate’. In October the wording was ‘inflation in the near term will likely be held down by lower energy prices and other factors, the likelihood of inflation running persistently below 2 percent has diminished somewhat since early this year’. Adding increased importance to inflation releases moving forward the committee in December also stated that they will ‘continue to monitor inflation developments closely’.

Rate outlook – In October the FOMC statement read ‘based on its current assessment, that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program this month. Moving forward six weeks the committee state that they ‘can be patient in beginning to normalize the stance of monetary policy‘ with the guidance ‘consistent with its previous statement that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program in October’.

Reinvestment of asset purchases – There was no discussion on this in the October statement given the decision was made to cease additional asset purchases at that meeting. In December they note ‘the Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizeable levels, should help maintain accommodative financial conditions.

Voting Patterns – In October the committee voted 9-1 in favour of the policy action. In December the consensus narrowed with seven voting for the action with three dissenting. On the hawkish side Richard Fisher stated that ‘while the Committee should be patient in beginning to normalize monetary policy, improvement in the U.S. economic performance since October has moved forward, further than the majority of the Committee envisions, the date when it will likely be appropriate to increase the federal funds rate’. Adding a second dissenter to the hawkish camp Charles Plosser noted that ‘the statement should not stress the importance of the passage of time as a key element of its forward guidance and, given the improvement in economic conditions, should not emphasize the consistency of the current forward guidance with previous statements’. On the dovish side of the ledger Narayana Kocherlakota, as was the case in October, ‘believed that the Committee’s decision, in the context of ongoing low inflation and falling market-based measures of longer-term inflation expectations, created undue downside risk to the credibility of the 2 percent inflation target’.

GDP – Few changes were made from the forecasts offered in October. The expected range for 2016 was widened slightly.

Unemployment – Downward revisions to unemployment were made for 2015 and 2016 reflecting recent strengthening in labour market conditions.

Core PCE inflation – The outlook for 2015 was lowered whilst that for 2016 was widened. It is interesting to see that the median FOMC forecast is for inflation to run below their 2% target until at least 2016.

Projected path for the Fed Funds rate (aka ‘the dots’)

The median outlook for the Fed funds rate at the end of 2015, 2016 and 2017 were all revised lower, something that indicates a slightly less-aggressive policy tightening. That for the longer-term remained unchanged. The changes are expressed in the chart below:

In her accompanying press conference Yellen stated that the committee are unlikely to start policy normalisation ‘for at least the next couple of meetings’. Asked later she confirmed that a couple ‘means two’. Dismissing the view that policy normalisation will only coincide with a meeting where a press conference is held she stated that when it occurs a conference call would likely be held. On inflation Yellen noted that the committee would like to have confidence that it will move higher before normalising policy. While falling energy prices are contributing to disinflationary pressures she also noted that this would likely be a ‘net positive’ to the economy. On the labour market she stated that the labour market recovery will put upward pressure on wages and prices. Last but not least, on the pace of policy tightening, she stated that it is anticipated to be ‘relatively gradual’.

The FOMC are certainly more hawkish in December than what they were in October. While they have lowered their inflation and median forecast for the fed funds rate at the end of 2015 it is clear they expect further tightening in the labour market to create additional wage pressures. Using their median fed funds rate forecast of 1.25% for the end of 2015, along with the notion expressed by Yellen that it will be at least a couple of meetings before they begin to normalise policy, something that would exclude January and March next year, it suggests the FOMC will look to tighten policy in four of the remaining six meetings in 2015. With external disinflationary pressures building this suggests that most of the heavy lifting will have to come from higher employee wages. While not to dismiss the fact the labour market is tightening, it is, one month of above-forecast average hourly earnings growth does not create a trend. This is clearly demonstrated in the annualised rate which has remained range bound for the best part of two years. Unless we get several months of November-like wages growth in a row the schedule for policy tightening looks overly optimistic.